13.4 (EXPANDED) MANAGING EARNINGS
1. Recording revenue before its earned
 Stuff the channel: force customer to take more than
they need, pay later, return whenever (hard to prove)
 book as revenue at sale, even LT contracts, aggressive
 vendor financing (what looks like growth is really bad
receivables, various telcos)
2. Inventing revenue
 McKesson had two books
 Revenue swap arrangements between firms with
different quarterly reporting months.
 Boosting profits with non-recurring items
 gains from investments were treated as income during
the bubble, now losses are treated as non-operating.
 Gains and losses from currency translation, is
operational but not treated as such.
3. Shifting expenses to later periods
 Capitalize software development costs for many years,
rather than booking as expenses, makes earnings look
better. E.g many software companies
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 Raise assumed rate of return on pension fund, so
decrease in funding costs, increase in profits,GE.
 Failing to disclose or record liabilities: Rite Aid
reduced payables because of discounts it “felt” was due
though they never got it !
4. Shifting income to later periods
 MSFT used to postpone revenue recognition till long
after software sale, (unearned revenue).
 WR Grace maintained excess earnings in all-purpose
reserve.
5. Shifting future expenses to earlier periods
 Front-load write-off of unproductive assets to make
future E look good and create “growth”.
 Asset restructuring: match unusual gain from asset sale
with restructuring charges (GE)
6. Is all this a good thing or a bad thing?
Ok if compatible with GAAP ?
New industries with evolving acctg practices ?
Don’t we do smooth things at the personal level too ?
Can’t investors figure this out ?
So why bother with earnings at all? Why not use free cash
flow as to equity as above ? Companies then began to
redefine free cash flow in their reports to suit their purposes
(EDS, Tyco).
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13.5 DISCOUNTED CASH FLOW VALUATION
Could value equity directly or value the firm and then take out the
non-equity claims. The DDM’s we did earlier are an illustration of
the former, where dividend flows to equity holders are discounted
at the cost of equity.

Estimate life: Usually as 1 or 2 stages, high growth + stable.

Estimate Cash flows to the firm
Plus:
Minus:
Minus:
Equals:
Earnings before interest and taxes * ( 1- tax rate)
Depreciation
Capital Expenditure
Change in Working Capital
Cash flow to the firm
I. EBIT = Earnings before interest and taxes
 must reflect only income and expenses from operations,
not financing (e.g) interest
 If there are no earnings, use revenue * operating margin
 Operating leases are treated as financial expenses but
should be treated as operating expenses (so adjust
EBIT)
 R&D is treated as operating but could be a capital
expense
 Some tech companies have argued that SG&A is a
capital expense not operating one (AOL and free-CDs)
 Tax rate: Marginal or effective rate?
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Marginal understates income early but more accurate in
later years. Effective rate really measures the difference
between acctg and tax books.
 Estimate growth rate for this over time as: a) historical
growth in EPS and/or dividends, b) arithmetic or
geometric; c) sustainable growth).
II. Net capital expenditures = Capital Expense –Depreciation
 Includes research and development expenses,
acquisitions (look in SOCF under investment activities,
can normalize).
 Think of the depreciation as a cash flow that finances
capital expense
 Firms in high growth phase need more, for mature
firms, this may net to zero
III
Change in Net Working Capital
 Increases in NWC ties up cash and reduces cash flow
 Cleaner to think of it as Non Cash CA – Non Debt CL
IV. Estimate discount rate
Weighted average cost of capital (WACC) using MV weights
this reflects the cost of issuing securities to finance projects.
C.I. Cost of equity = Risk-free + Equity beta * Risk Premium
a) Risk-free rate => no default risk, no reinvestment risk,
 match duration of instrument with life
 use real rates on inflation indexed bond ?
 10-year bond yield presently 4.1%
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 for some countries, govt debt may not be riskfree
(Brazil?) or there may be no long govt security
b) Risk premium => even historical has some variance.
Stocks – T-bills
Arith
Geom
1928-2000 8.4
7.2
1990-2000 11.3
8.4
Stocks – T-bonds
Arith
Geom
6.6
5.6
12.7
8.9
 Are investor risk patterns are changing
 When the Fed stays accommodative (as now),
there is an implicit reduction in the risk premium
(the Fed put)
Could reverse the logic and estimate an “implied” risk
premium from current stock prices, e.g
E(R) = D1/P0 + g and take out a risk free rate.
Has varied from 2% in 2000, 3% in the 1960’s and 6.25% in
the late 1970’s.
c) Beta estimation




Slope of regression of stock return against market return
Higher with both operating and financial leverage
Adjust for leverage, βl = βu * [1 + {(1-t) * D/E}
Depends on the time frame, Value line uses adjusted betas,
probably the easiest to use and reflect changes over time
as firm matures
 Could also do it bottom-up or fundamental betas (take
weighted beta of different lines of business)
.
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C.II. Cost of Debt = After-tax yield to maturity
FINALLY, THE VALUE OF THE FIRM IS:
PV of operating assets, (the CF’s above, discounted at the WACC)
Plus: Cash and Non operating assets.
AND
The Value of the Equity = Value of the Firm – Value of Debt.
CAVEATS
a) www.valuepro.net has a simpler DCF format.
b) There is a paper on blackboard that lists “75 common and
uncommon errors in valuations performed by financial
analysts !!
c) Models are geared more towards traditional manufacturing
firms. Cash flow fluctuations for financial firms and cyclical
firms are tied more closely to economic activity and call for
timing the business cycle. Firms in trouble, or restructuring
or under acquisition make CF estimation difficult.
d) Because of the accounting games that companies play,
tremendous attention is devoted to getting the cash flow
estimates right.
e) However, valuations are often much more sensitive to small
variations in the market-driven estimates that comprise the
discount rate.
f) Even after such care, considerable sensitivity analysis is
warranted.
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